American Depositary Receipts

An American depositary receipt (ADR) is a negotiable certificate that trades like a common stock and is issued by a U.S. bank; it represents shares of a non-U.S. publicly traded company. ADRs are priced in U.S. dollars, and dividends are paid out in U.S. dollars. The actual shares of the foreign company are held by a custodian bank in the company's home country, subject to the terms specified on the ADR certificate.

Foreign Investing Options

An investor has multiple options when choosing to invest in foreign securities. Investing in mutual funds that buy foreign stock is the simplest way, but what about investors who want to pick and invest in individual stocks? One option is to buy shares on a foreign exchange. However, the transactions are denominated in the exchange's home currency, you or your broker must have access to that foreign exchange in order to place trades, and you have issues of international settlement, global custody, foreign brokerage, currency conversions and multi-currency accounting. This method can be cumbersome and costly.

A handful of foreign companies list their stock on U.S. exchanges, but the number of companies that do this is small due to high costs and strict regulations. The New York Stock Exchange, for instance, allows non-U.S. companies to be listed on the exchange if the company meets all requirements both for the exchange and the SEC, pays a dual-listing fee, and produces frequent reports in English for traders.

ADRs allow U.S.-based investors to bypass these obstacles when investing in foreign stocks.

How It Works

ADRs are foreign shares deposited with a U.S. bank, which then issues certificates representing the shares to investors. The ADR is issued by the bank after underlying shares have been deposited in a local custodian bank. Some ADRs represent several foreign shares (for example, a 100 share lot) or partial shares in order to prevent unusual share prices due to exchange rates. The goal is to package and therefore price the ADR at a level similar to a typical U.S. stock.

A depositary receipt certificate states any stipulations of the investment, such as payment of dividends and shareholder voting.

All ADRs are denominated in U.S. dollars and any dividends are also paid in U.S. dollars.

When an investor wishes to sell the ADR, it is either sold to another U.S. investor or it is canceled and the underlying shares are sold to a non-U.S. investor.

Types

There are two main types of ADRs: sponsored and unsponsored. An unsponsored ADR is created without the company's involvement and is typically traded through the over-the-counter (OTC) market.

An ADR created with a company's involvement is called a sponsored ADR and classified into one of three levels:

A Level I ADR means a company does not meet SEC regulation and reporting requirements and is traded only in the OTC market.

A Level II ADR registers with the SEC, complies with all regulations and is listed on the New York or NASDAQ exchange.

Finally, a Level III ADR meets all SEC requirements, is traded on a U.S. exchange and the company is allowed to raise capital in the U.S. through a public offering of ADRs.

ADRs that are listed on U.S. exchanges provide shareholders with the same level of information as any U.S. security. Typically, trading information is readily available, the company's financial reports conform to U.S. accounting standards, and the SEC regulates the company's disclosure of information to investors, with annual reports and other materials provided in English.

Information on ADRs that are traded over-the-counter is more limited, company financials do not conform to U.S. standards and the SEC does not require companies to communicate with shareholders on a regular basis.

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Investors can always use a broker to purchase ADRs.

Some ADRs offer direct purchase plans as well as dividend reinvestment plans: The former allows investors to purchase initial shares directly from the company and the latter allows automatic purchases of new shares with any dividends received. A multitude of banks allow investors to trade these shares, such as Bank of New York and JP Morgan Chase..

When selling an ADR, it trades just like a U.S. stock and can be sold to another U.S. investor.

Investor Suitability

Investing in foreign stocks can be risky. Foreign markets can be volatile, reacting to economic, political and social news from the country and surrounding countries, and U.S.-based investors can see a decline in the dollar value of their holdings due to currency fluctuations.

Tax Consequences

Any dividends paid by the ADR are generally taxable, just like dividends on U.S. shares. In addition, taxes may be withheld by the ADR company's local government. Depending on individual circumstances, foreign taxes withheld might be applied as a credit against U.S. taxes, or tax reclaim opportunities may be offered. A tax advisor can help with any confusion.

Also, as with U.S. stocks, when ADR shares are sold, any capital gains are taxed.

The Pros

Foreign Diversification: Investing in ADRs allows U.S.-based investors to further diversify their individual stock holdings while avoiding many of the problems associated with direct foreign investment.

U.S. Reporting Standards: ADRs that are Level II or Level III ensure that certain reporting standards have been met by the underlying company.

Denomination in U.S. Dollars: Shares are bought and sold in U.S. dollars and all dividends are paid in U.S. dollars.

Lower Costs: Buying shares on a foreign exchange directly from the company can be costly. Individual investors may find it more cost effective to purchase ADRs through a U.S. exchange or by participating in a direct purchase program.

Dividend Reinvestment: Some ADRs allow investors to use dividends to purchase additional shares.

The Cons

Lack of Diversification: While many foreign companies do offer ADRs, they still only represent a portion of the overseas market. Companies issuing ADRs tend to be larger in size. This may lead to an under-diversified international portion of an overall investment portfolio if ADRs are the only foreign holdings.

Foreign Market Risk: ADRs are subject to all of the risks of the underlying holding, including foreign market and currency risk.

Additional Information

Bank of New Yorkwww.adrbny.com
The Bank of New York is a major issuer of ADRs. The site offers an overview of ADRs, a glossary, and tips on how to purchase ADRs. You can search for ADRs and access links to additional research.

The Bank of New York also offers a direct purchase and dividend reinvestment program for ADRs.

J.P. Morganwww.adr.com
JP Morgan is major issuer of ADRs. This site provides resources for screening and researching ADRs. In addition, a portfolio tool tracks foreign stocks and provides alerts. JP Morgan offers a direct purchase program for ADRs.

Discussion

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